We remain positive on the Power Utilities sector which is the right sector for investors looking for defensive play under the current uncertain investment climate. Although fuel costs are set to increase in view of rising coal prices of late and the scheduled hike in gas prices, these factors have neutral earning impact to TENAGA as the ICPT framework will address the issues in the coming Dec-Review. In this case, tariff rebate for 1H2017 is likely to be reduced further. On the other hand, the IPPs’ capacity payments are guaranteed by PPAs which keep earnings uncertainty in check. In all, TENAGA remains as our TOP PICK for the sector for its earnings quality profile and index-weighting status. Besides, we also like small cap PESTECH as an alternative play for its explosive earnings growth story.

Problem solved for Track 4A? Early August, Tenaga Nasional Bhd (TENAGA, OP; TP: RM17.50) announced that it has signed a PPA agreement with Southern Power Generation Sdn Bhd, a wholly-owned subsidiary of SIPP Energy Sdn Bhd for the Track 4A project. This PPA signing is long overdue as the Track 4A project was directly awarded to the SIPP Energy-led consortium which consists of YTL Power International Bhd (YTLPOWR, MP; TP: RM1.54) and TENAGA more than two years ago in June 2014. However, YTLPOWR pulled out from the consortium two weeks later as the controversial Track 4A drew criticism from the public as the direct negotiation award was seen as a setback to the sector reform while TENAGA decided to part ways with SIPP Energy for the project before meeting the previous submission dateline by September last year. With the PPA finally signed, the expected COD of this 1,440MW gas-fired combined cycle electricity generating facility is January 2020. Question is who will be SIPP Energy’s partner for this project since it has no experience in this field. To meet the COD dateline, the plant has to be started construction at least by mid-2017; thus it has quite a tight dead-line to find a new partner. We believe the new partner could be any of the existing players like TENAGA, YTLPOWR or Malakoff Bhd (MALAKOF, MP; TP: RM1.79).

New plant in the pipeline. In early Aug, Tadmax Resources Bhd (TADMAX, Not Rated) announced that it has been awarded a contract to build a new 1,000MW combined cycle gas-fired power plant in Pulau Indah. This was a surprise to the market as TADMAX is not an industry player and there was also no tender process prior to the announcement. We maintain our view that any new power plant should go through open tender to safeguard stakeholders’ interest. Meanwhile, it was reported that the Ministry of Energy, Green Technology and Water (Kettha) said TADMAX was given the contract because it has land that is ideal for the project and TADMAX needed to work with TENAGA as part of the condition for the award of the project. TADMAX had been given until Aug 2017 to implement a detailed feasibility study of the whole project development. Based on the timeline, the power plant is expected to be come on-stream by 2021 or 2022. On the other hand, the dispute on PPA Extension for YTLPOWR’s Paka Power Plant has yet to be solved pertaining to the land lease agreement between YTLPOWR and TENAGA. It was reported that TENAGA has taken this to court, thus the PPA Extension which was supposed to start in Mar 2016 to Dec 2018 is expected to be delayed.

Rising coal price is earnings neutral. Since June, coal prices have rallied sharply by >30% mainly led by supply shortages in China amid increasing demand that pushed prices above USD70/mt levels, which has not been seen in the past two years. With rising coal price and a RM1.50/mmbtu scheduled upward adjusted in gas price, TENAGA expects to see higher fuel costs in coming quarters which will be reflected in the bi-yearly Tariff Review in this Dec window. As the current coal price is still below the ICPT reference price of USD87.50/mt, TENAGA is still likely to record fuel cost over-recovery in coming quarters with tariff rebate for 1H 2017 under the Dec Review likely to be reduced further from current of 1.5s sen/kWh. Thus, this latest rising cost should have a neutral impact to TENAGA’s earnings albeit expected to be weaker in the near term as ICPT adjustment will only be reflected in the next review in Dec.

Defensive is key, OVERWEIGHTing the sector. In the current uncertain times, we believe the Power Utilities is the right sector for investors looking for defensive play. Earnings of TENAGA are fairly defensive with the ICPT framework which has a fuel cost pass-through mechanism eliminating fuel cost risk while profitability of IPPs is backed by PPAs which guarantee capacity payment as long as requirements are met. In addition, valuation for the overall sector is also not demanding at CY17 12.5x PER which is below the FBMKLCI’s 17x. TENAGA remains as our Top Pick for the sector given its undemanding valuation, which is backed by its quality earnings profile and index weighting status. On the other hand, we continue to like small cap PESTECH as an alternative sector play for its explosive earnings growth story, with near-term strong contract flows expected.

Source: Kenanga Research - 5 Oct 2016